As we pointed out in our last blog post, it’s incredibly important to have an up to date overview of your financials and key numbers. And one of the most critical areas of your accounts to keep your eye on is the business’ underlying profitability.
If you have a firm grip on your profit numbers, you get the best possible understanding of the overall health of the business as a whole.
And with the right profit and sales targets in mind, you can create realistic, workable strategic plans and drive the motivation, focus and execution effectiveness of the whole team.
So, how do you get in control of your profits?
The starting point is to set an agreed ‘Acceptable Level of Profit’ (ALP) for your existing business model and to base your strategic decision-making around this key number.
Getting a handle on profit margins
To begin with, it’s worth defining the two main profit ratios you’ll come across when running a small business.
1. Gross profit margin:
Your gross profit margin figure shows you the portion of money that’s left over from your company’s revenues once you’ve deducted the cost of the goods sold (COGS).
It’s a good indicator of the financial health of the business and shows whether you’re bring in sufficient profits to cover your operating costs, and with enough money left in the pot to fund growth and expansion.
You can work out your gross profit margin using this simple formula:
Revenues – COGS
= Gross profit margin
2. Net profit margin:
Your net profit margin is related to the gross margin, but also takes into account the company’s operating costs and other expenses, not just the COGS.
As such, it can be a more holistic measure of the financial effectiveness of your business model.
You can find your net profit margin using this formula:
Revenues – COGS – Operating costs – All other expenses
= Net profit margin
Understanding these profit ratios is a vital part of your financial management, and as the CEO or CFO you should be able to understand the profit margins for your business.
As a rough benchmark, an acceptable gross profit margin can vary between 40 to 70%, depending on the industry your business works in, and a good net profit margin to maintain would be anything from 20% upwards.
Defining your Acceptable Level of Profit
So, how do your profit margins relate to your ALP?
Well, to work out your company’s ALP you first need to know your gross margin figure. And armed with that number, your fixed costs and your desired profit, you can work out a very important figure: the sales you need to make to meet your profit goal.
The formula is as follows:
Fixed (Overhead) Costs + Profit Desired
= Sales Required for Profit Goal
So, why is this ALP number important?
The answer is that your ALP is one of the key drivers behind your entire business strategy. By agreeing on a clear profit target, you build an equally well-defined sales target for your team to aim for.
And with a transparent sales objective to attain, you give focus to your business strategy, motivation to your sales team and an overall goal to the whole business.
It puts a flag in the top of profit mountain and says ‘Get climbing and you’ll make it to the top!’
Understanding the impact on your ALP
You never make a business decision in isolation. Every action that you take regarding the running of the organization has some kind of impact in another area of the business – it’s Newtonian physics but in a business context.
So when you make a change, it’s vital to understand the potential impact on your ALP.
For example, if the business is looking healthy, it may be tempting to hire more people and expand the team. But more employees results in a bigger payroll cost, and that impacts on the COGS and the end figure from your ALP formula.
The phrase to bear in mind is ‘look before you leap’.
It’s important to look at each and every business decision and to consider how it could affect the variables in your profit equation.
Putting up your prices seems like an obvious way to make more profit, but if customers dislike the price increase and your sales numbers drop, then so will your overall profits.
This is where the merits of forecasting can be invaluable. The new breed of cloud-based reporting and forecasting solutions give you the ability to plug in the key variables for your model and produce extremely detailed forecasts of sales and profits, based on data and actuals pulled through from your cloud accounting software.
And who wouldn’t make better business decisions with a crystal ball that lets them see the future profitability of their business?
Start improving your profits
At Holden Moss, profit improvement is one of the core pillars in our Awesome 8 approach to business advice.
We know that a key focus on understanding and enhancing your profitability is crucial to the growth of any aspirational small business. And by looking in granular detail at the workings of your business model that we can work with you to review, analyse and improve the profits you see coming from your business.
Take our free Profit Improvement Review and see how you can create a more profitable enterprise.